x QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31,
2018

OR

o TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from __________
to __________.

Commission file number 001-31972

TELKONET, INC.

(Exact name of Registrant as specified in
its charter)

Utah

87-0627421

(State or Other Jurisdiction
of Incorporation or Organization)

(I.R.S. Employer
Identification No.)

20800 Swenson Drive, Suite 175, Waukesha, WI

53186

(Address of Principal Executive Offices)

(Zip Code)

(414) 302-2299

(Registrant’s Telephone Number, Including
Area Code)

Indicate
by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act
during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days. Yes x No
¨

Indicate
by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the
preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No
¨

Indicate by check mark
whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company,
or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller
reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o (Do not check if a smaller reporting company)

Smaller reporting company x

Emerging growth company o

If
an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for
complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate
by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. Yes o No
x

The number of shares
outstanding of the registrant’s common stock, par value $0.001 per share, as of April 30, 2018 is 133,989,919.

Series A, par value $.001 per share; 215 shares issued, 185 shares outstanding at March 31,
2018 and December 31, 2017, preference in liquidation of $1,544,394 and $1,526,141 as of March 31, 2018 and December 31, 2017,
respectively

1,340,566

1,340,566

Series B, par value $.001 per share; 538 shares issued, 52 shares outstanding at March 31, 2018 and December 31, 2017, preference in liquidation of $419,393 and $414,258 as of March 31, 2018 and December 31, 2017, respectively

362,059

362,059

Common stock, par value $.001 per share; 190,000,000 shares authorized; 133,989,919 and 133,695,111 shares issued and outstanding at March 31, 2018 and December 31,2017, respectively

133,989

133,695

Additional paid-in-capital

127,458,639

127,421,402

Accumulated deficit

(121,338,822

)

(119,724,656

)

Total stockholders’ equity

7,956,431

9,533,066

Total Liabilities and Stockholders’ Equity

$

11,601,161

$

12,547,583

See accompanying notes to the unaudited
condensed consolidated financial statements

3

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS

(UNAUDITED)

For the Three Months Ended

March 31,

2018

2017

Revenues, net:

Product

$

1,503,658

$

1,810,385

Recurring

101,538

102,842

Total Net Revenues

1,605,196

1,913,227

Cost of Sales:

Product

994,237

1,008,045

Recurring

59,997

30,018

Total Cost of Sales

1,054,234

1,038,063

Gross Profit

550,962

875,164

Operating Expenses:

Research and development

438,780

378,456

Selling, general and administrative

1,276,903

1,769,693

Depreciation and amortization

16,915

9,909

Total Operating Expenses

1,732,598

2,158,058

Operating Loss

(1,181,636

)

(1,282,894

)

Other (Expenses) Income:

Interest (expense), net

(2,530

)

(10,353

)

Total Other (Expenses)

(2,530

)

(10,353

)

Loss from Continuing Operations before Provision for Income Taxes

(1,184,166

)

(1,293,247

)

Provision for Income Taxes

–

991

Net loss from continuing operations

(1,184,166

)

(1,294,238

)

Discontinued Operations:

Gain from sale of discontinued operations (net of tax)

–

6,384,871

Income from discontinued operations (net of tax)

–

571,802

Net (loss) income attributable to common stockholders

$

(1,184,166

)

$

5,662,435

Net (loss) income per common share:

Basic - continuing operations

$

(0.01

)

$

(0.01

)

Basic - discontinued operations

$

–

$

0.05

Basic – net (loss) income attributable to common stockholders

$

(0.01

)

$

0.04

Diluted - continuing operations

$

(0.01

)

$

(0.01

)

Diluted - discontinued operations

$

–

$

0.05

Diluted – net (loss) income attributable to common stockholders

$

(0.01

)

$

0.04

Weighted Average Common Shares Outstanding used in computing basic net loss per share

133,695,111

132,774,475

Weighted Average Common Shares Outstanding used in computing diluted net loss per share

133,695,111

133,520,471

See accompanying notes to the unaudited
condensed consolidated financial statements

4

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(UNAUDITED)

THREE MONTHS FROM JANUARY 1, 2018 THROUGH
MARCH 31, 2018

Series A Preferred Stock

Series A Preferred Stock

Series B Preferred Stock

Series B Preferred Stock

Common

Common Stock

Additional Paid-in

Accumulated

Total Stockholders’

Shares

Amount

Shares

Amount

Shares

Amount

Capital

Deficit

Equity

Balance at December 31, 2017

185

$

1,340,566

52

$

362,059

133,695,111

$

133,695

$

127,421,402

$

(119,724,656

)

$

9,533,066

January 1, 2018, Cumulative effect of a change in accounting principle
related to ASC 606, net of tax

–

–

–

–

–

–

–

(430,000

)

(430,000

)

Shares issued to directors

–

–

–

–

294,808

294

35,706

–

36,000

Stock-based compensation expense related to employee stock options

–

–

–

–

–

–

1,531

–

1,531

Net loss

–

–

–

–

–

–

–

(1,184,166

)

(1,184,166

)

Balance at March 31, 2018

185

$

1,340,566

52

$

362,059

133,989,919

$

133,989

$

127,458,639

$

(121,338,822

)

$

7,956,431

See accompanying notes to the unaudited
condensed consolidated financial statements

5

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS

(UNAUDITED)

For the Three Months Ended

March 31,

2018

2017

Cash Flows from Operating Activities:

Net (loss) income

$

(1,184,166

)

$

5,662,435

Less: Net income from discontinued operations

–

(571,802

)

Gain on sale of discontinued operations

–

(6,384,871

)

Net loss from continuing operations

(1,184,166

)

(1,294,238

)

Adjustments to reconcile net loss from continuing operations to cash used in operating activities of continuing operations:

Cash, cash equivalents and restricted cash at the beginning of the period

9,195,595

791,858

Cash, cash equivalents and restricted cash at the end of the period

$

8,136,859

$

11,604,999

See accompanying notes to the unaudited
condensed consolidated financial statements

6

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS (Continued)

(UNAUDITED)

Three Months Ended

March 31,

2018

2017

Supplemental Disclosures of Cash Flow Information:

Cash transactions:

Cash paid during the period for interest

$

12,228

$

10,484

See accompanying notes to the unaudited
condensed consolidated financial statements

7

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

NOTE A – BASIS OF PRESENTATION
AND SIGNIFICANT ACCOUNTING POLICIES

A summary of the significant accounting
policies applied in the preparation of the accompanying condensed consolidated financial statements follows.

General

The accompanying unaudited condensed consolidated
financial statements of Telkonet, Inc. (the “Company”, “Telkonet”) have been prepared in accordance with
Rule S-X of the Securities and Exchange Commission (the “SEC”) and with the instructions to Form 10-Q. Accordingly,
they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial
statements.

In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair presentation have been included. However, the results
from operations for the three months ended March 31, 2018, are not necessarily indicative of the results that may be expected for
the year ending December 31, 2018. The unaudited condensed consolidated financial statements should be read in conjunction with
the consolidated December 31, 2017 financial statements and footnotes thereto included in the Company's Form 10-K filed with the
SEC. Refer to Note C – Revenue, for the adoption of a new revenue recognition standard in the first quarter of 2018.

Business and Basis of Presentation

Telkonet, formed in 1999 and incorporated
under the laws of the state of Utah, is the creator of the EcoSmart Platform of intelligent automation solutions designed to optimize
energy efficiency, comfort and analytics in support of the emerging Internet of Things (“IoT”).

In 2007, the Company acquired substantially
all of the assets of Smart Systems International (“SSI”), which was a provider of energy management products and solutions
to customers in the United States and Canada and the precursor to the Company’s EcoSmart platform. The EcoSmart platform
provides comprehensive savings, management reporting, analytics and virtual engineering of a customer’s portfolio and/or
property’s room-by-room energy consumption. Telkonet has deployed more than a half million intelligent devices worldwide
in properties within the hospitality, military, educational, healthcare and other commercial markets. The EcoSmart platform is
rapidly being recognized as a leading solution for reducing energy consumption, operational costs and carbon footprints, and eliminating
the need for new energy generation in these marketplaces – all while improving occupant comfort and convenience.

On March 28, 2017, the Company sold substantially
all of the assets of its wholly-owned subsidiary, EthoStream, LLC. Refer to Note M for further details.

The condensed consolidated financial statements
include the accounts of the Company and its wholly-owned subsidiaries, Telkonet Communications, Inc. The prior year accounts of
EthoStream LLC have been classified as discontinued operations on the consolidated statement of operations and the consolidated
statement of cash flows. All significant intercompany balances and transactions have been eliminated in consolidation.

We have financed our operations since inception
primarily through private and public offerings of our equity securities, the issuance of various debt instruments and asset based
lending.

The
Company reported a net loss from continuing operations of $1,184,166 for the three months ended March 31, 2018, had cash used in
operating activities from continuing operations of $991,884, had an accumulated deficit of $121,338,822 and total current assets
in excess of current liabilities of $7,890,259 as of March 31, 2018.

Income (Loss) per Common Share

The Company computes earnings per share
under Accounting Standards Codification (“ASC”) 260-10, “Earnings Per Share”. Basic net income (loss) per
common share is computed using the treasury stock method, which assumes that the proceeds to be received on exercise of outstanding
stock options and warrants are used to repurchase shares of the Company at the average market price of the common shares for the
year. Dilutive common stock equivalents consist of shares issuable upon the exercise of the Company's outstanding stock options
and warrants. For the three months ended March 31, 2018 and 2017, there were 3,557,399 and 6,132,725 shares of common stock underlying
options and warrants excluded due to these instruments being anti-dilutive, respectively.

8

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

The U.S. Tax Cuts and Jobs Act (“Tax
Act”) was enacted on December 22, 2017. The Tax Act makes broad complex changes to the U.S. tax code including, but not limited
to, reducing the U.S. federal corporate tax rate from 35% to 21%, requiring companies to pay a one-time transition tax on earnings
of certain foreign subsidiaries that were previously tax deferred, and creating new taxes on certain foreign sourced earnings and
additional limitations on the deductibility of interest.

The SEC issued Staff Accounting Bulletin
No. 118 (SAB 118) in December, 2017, to provide guidance on accounting for the effects of the Tax Act. SAB 118 provides for a measurement
period of up to one year from the Tax Act enactment date for companies to complete their assessment of and accounting for those
effects of the Tax Act. Under SAB 118, a company must first reflect the income tax effects of the Tax Act for which the accounting
is complete in the period of the date of enactment. To the extent the accounting for other income tax effects is incomplete, but
a reasonable estimate can be determined, companies must record a provisional estimate to be included in their financial statements.
For any income tax effect for which a reasonable estimate cannot be determined, an entity must continue to apply ASC 740 based
on the provisions of the tax laws in effect immediately prior to the Tax Act being enacted until such time as a reasonable estimate
can be determined. The Company requires additional time to complete its analysis of the impacts of the Tax Act and therefore its
accounting for the Tax Act is provisional but is a reasonable estimate based on available information. The Company will complete
its analysis and finalize its accounting for this provisional estimate during the one year measurement period as prescribed by
SAB 118.

Use of Estimates

The preparation of financial statements
in conformity with United States of America (U.S.) generally accepted accounting principles (GAAP) requires management to make
certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting
period. Estimates are used when accounting for items and matters such as revenue recognition and allowances for uncollectible accounts
receivable, inventory obsolescence, depreciation and amortization, long-lived assets, taxes and related valuation allowance, income
tax provisions, stock-based compensation, and contingencies. The Company believes that the estimates, judgments and assumptions
are reasonable, based on information available at the time they are made. Actual results may differ from those estimates.

Income Taxes

The Company accounts for income taxes in
accordance with ASC 740-10 “Income Taxes.” Under this method, deferred income taxes (when required) are provided based
on the difference between the financial reporting and income tax bases of assets and liabilities and net operating losses at the
statutory rates enacted for future periods. The Company has a policy of establishing a valuation allowance when it is more likely
than not that the Company will not realize the benefits of its deferred income tax assets in the future.

The Company adopted ASC 740-10-25, which
prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position
taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on derecognition, classification, treatment
of interest and penalties, and disclosure of such positions.

Revenue from Contracts with Customers

Accounting Standards Codification Topic
606, Revenue from Contracts with Customers (“ASC 606, the Standard”) supersedes nearly all legacy revenue recognition
guidance. ASC 606 outlines a comprehensive five-step revenue recognition model based on the principle that an entity should recognize
revenue based on when an it satisfies its performance obligations by transferring control of promised goods or services in an amount
that reflects the consideration to which the entity expects to be entitled in exchange for said goods or services.

Identify the customer contracts

The Company accounts for a customer contract
under ASC 606 when the contract is legally enforceable. A contract is legally enforceable when all of the following criteria are
met: (1) the contract has been approved by the Company and the customer and both parties are committed to perform their respective
obligations, (2) the Company can identify each party’s rights regarding goods or services transferred, (3) the Company can
identify payment terms for goods or services transferred, (4) the contract has commercial substance, and (5) collectability of
all the consideration to which the Company is entitled in exchange for the goods or services transferred is probable.

9

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

A contract does not exist if each party
to the contract has the unilateral right to terminate a wholly unperformed contract without compensating the other party (or parties).
Nearly all of the Company’s contracts do not contain such mutual termination rights for convenience. All contracts are in
written form.

Identify the performance obligations

The Company will enter into product only
contracts that contain a single performance obligation related to the transfer of EcoSmart products to a customer.

The Company will also enter into certain
customer contracts that encompass product and installation services, referred to as “turnkey” solutions. These contracts
ultimately provide the customer with a solution that enhances the functionality of the customer’s existing equipment. For
this reason, the Company has determined that the product and installation services are not separately identifiable performance
obligations, but in essence represent one, combined performance obligation (“turnkey”).

The Company also offers post-installation
support services to customers. Support services are considered a separate performance obligation.

Determine the transaction price

The Company generally enters into contracts
containing fixed prices. It is not customary for the Company to include contract terms that would result in variable consideration.
In the rare situation that a contract does include this type of provision, it is not expected to result in a material adjustment
to the transaction price. The Company regularly extends pricing discounts; however, they are negotiated up front and adjust the
fixed transaction price set out in the contract.

Customer contracts will typically contain
upfront deposits that will be applied against future invoices, as well as customer retainage. The intent of any required deposit
or retainage is to ensure that the obligations of either party are honored and follow customary industry practices. In addition,
the Company will typically be paid in advance at the beginning of any support contracts, consistent with industry practices. None
of these payment provisions are intended to represent significant implicit financing. The Company’s standard payment terms
are thirty days from invoice date. Products are fully refundable when returned in their original packaging without damage or defacing
less a restocking fee not to exceed fifty (50%) percent of the product’s price. Historical returns have shown to be immaterial.
The Company offers a standard one-year assurance warranty. However customers can purchase an extended warranty. Under the new standard,
extended warranties are accounted for as a service warranty, requiring the revenue to be recognized over the extended service periods.
Contracts involving an extended warranty are immaterial and will continue to be combined with support revenue and recognized on
a straight-line basis over the support revenue term.

Allocate the transaction price to the performance obligations

Revenues from customer contracts are
allocated to the separate performance obligations based on their relative stand-alone selling price (“SSP”) at
contract inception. The SSP is the price at which the Company would sell a promised good or service separately. The best
evidence of an SSP is the observable price of a good or service when the entity sells that good or service separately in
similar circumstances and to similar customers. However, turnkey solutions are sold for a broad range of amounts resulting
from, but not limited to, tiered discounting for value added resellers (“VAR”) based upon committed volumes and
other economic factors. Due to the high variability of our pricing, the Company cannot establish a reliable SSP using
observable data. Accordingly, the Company uses the residual approach to allocate the transaction price to performance
obligations related to its turnkey solutions.

All support service agreements, whether
single or multi-year terms, automatically renew for one-year terms at a suggested retail price (“SRP”). Support service
renewals are consistently priced and therefore would support the use of SRP as the best estimate of an SSP for such performance
obligations.

Recognize Revenue

The Company recognizes revenues from product
only sales at a point in time, when control over the product has transferred to the customer. As the Company’s principal
terms of sale are FOB shipping point, the Company primarily transfers control and records revenue for product only sales upon shipment.

10

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

A typical turnkey project involves the
installation and integration of 200-300 rooms in a customer-controlled facility and usually takes sixty days to complete. Since
control over goods and services transfers to a customer once a room is installed, the Company recognizes revenue for turnkey solutions
over time. The Company uses an outputs measure based on the number of rooms installed to recognize revenues from turnkey solutions.

Revenues from support services are recognized
over time, in even daily increments over the term of the contract.

Deferred revenue includes deferrals for
the monthly support service fees. Long-term deferred revenue represents support service fees that will be recognized as revenue
after March 31, 2019.

Transition

The Company adopted ASC 606 using a modified
retrospective approach to all contracts not completed as of January 1, 2018. Results for reporting periods beginning January 1,
2018 are presented under ASC 606, while prior period amounts were not adjusted and continue to be reported in accordance with the
Company’s historic accounting under Topic 605, Revenue Recognition. The Company recorded a net decrease to beginning retained
earnings of $0.43 million as of January 1, 2018 due to the cumulative impact of adopting ASC 606. The impact to beginning retained
earnings was primarily driven by the deferral of revenue for unfulfilled performance obligations related to the Company’s
turnkey solutions.

Guarantees and Product Warranties

The Company records a liability for potential
warranty claims in cost of sales at the time of sale. The amount of the liability is based on the trend in the historical ratio
of claims to sales, the historical length of time between the sale and resulting warranty claim, new product introductions and
other factors. The products sold are generally covered by a warranty for a period of one year. In the event the Company determines
that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves would be
charged to earnings in the period such determination is made. For the three months ended March 31, 2018 and the year ended December
31, 2017, the Company experienced returns of approximately 1% to 2% of materials included in the cost of sales. As of March 31,
2018 and December 31, 2017, the Company recorded warranty liabilities in the amount of $55,316 and $59,892, respectively, using
this experience factor range.

Product warranties for the three months
ended March 31, 2018 and the year ended December 31, 2017 are as follows:

March 31, 2018

December 31, 2017

Beginning balance

$

59,892

$

95,540

Warranty claims incurred

(6,023

)

(84,087

)

Provision charged to expense

1,447

48,439

Ending balance

$

55,316

$

59,892

NOTE B – NEW ACCOUNTING PRONOUNCEMENTS

In February 2016, the FASB issued ASU No.
2016-02, Leases (“ASU 2016-02”). The new standard establishes a right-of-use (ROU) model that requires a lessee to
record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified
as either finance or operating, with classification affecting the pattern of expense recognition in the statement of operations.
ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.
A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into
after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients
available. The Company is currently evaluating the impact of its pending adoption of ASU 2016-02 on its consolidated financial
statements. Upon adoption, the Company expects that the ROU asset and lease liability will be recognized in the balance sheets
in amounts that will be material.

11

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

In June 2016, the FASB issued ASU No.
2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU
2016-13 provides guidance for estimating credit losses on certain types of financial instruments, including trade
receivables, by introducing an approach based on expected losses. The expected loss approach will require entities to
incorporate considerations of historical information, current information and reasonable and supportable forecasts. ASU
2016-13 also amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets
with credit deterioration. The guidance is effective for fiscal years beginning after December 15, 2019, including interim
periods within those fiscal years. The guidance requires a modified retrospective transition method and early adoption is
permitted. The Company does not expect the adoption of ASU 2016-13 to have a material impact on its consolidated financial
statements.

Management has evaluated other recently
issued accounting pronouncements and does not believe that any of these pronouncements will have a significant impact on our consolidated
financial statements and related disclosures.

Accounting Standards Recently Adopted

Effective January 1, 2018, the Company
has adopted Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (“ASC 606, the Standard”),
which supersedes nearly all legacy revenue recognition guidance. ASC 606 outlines a comprehensive five-step revenue recognition
model based on the principle that an entity should recognize revenue based on when an it satisfies its performance obligations
by transferring control of promised goods or services in an amount that reflects the consideration to which the entity expects
to be entitled in exchange for said goods or services.

Effective January 1, 2018, the Company
has adopted ASU No. 2016-18, Statement of Cash Flows: Restricted Cash, (“Update 2016-18”). Update 2016-18
provides guidance on the classification of restricted cash in the statement of cash flows. The amendments are effective for interim
and annual periods beginning after December 15, 2017. The amendments in Update 2016-18 was adopted on a retrospective basis. Due
to the adoption of ASU 2016-18, the cash, cash equivalents and restricted cash presented in the Condensed Consolidated Statement
of Cash Flows for the three months ended March 31, 2018 and 20147 increased by $10,000 and $900,000 of restricted cash held as
of March 31, 2018 and 2017, respectively.

NOTE C– REVENUE

The following table presents the Company’s
product and recurring revenues disaggregated by industry for the three months ended March 31, 2018. Sales taxes and other usage-based
taxes are excluded from revenues.

Hospitality

Education

Multiple Dwelling Units

Government

Total

Recurring

$

90,924

$

10,460

$

154

$

–

$

101,538

Product

1,249,228

227,507

19,441

7,482

1,503,658

$

1,340,152

$

237,967

$

19,595

$

7,482

$

1,605,196

Contract assets

Contracts are billed in accordance with
the terms and conditions, either at periodic intervals or upon substantial completion. This can result in billing occurring subsequent
to revenue recognition, resulting in contract assets. Contract assets are presented as other current assets in the Condensed Consolidated
Balance Sheet. The balance of contract assets as of March 31, 2018 and at the date of adoption of ASC 606 was $0.64 million and
$0.35 million, respectively. There were $0.33 million of costs incurred to fulfill a contract in the closing balance of contract
assets.

Contract liabilities

Contracts are billed in accordance with
the terms and conditions, either at periodic intervals or upon substantial completion. Often, the Company will require customers
to pay a deposit upon contract signing that will be applied against work performed or products shipped. In addition, the Company
will often invoice the full term of support at the start of the support period. Billings that occur prior to revenue recognition
result in contract liabilities. As of March 31, 2018 and at the date of adoption of ASC 606, contract liabilities were $1.67 million
and $0.78 million, respectively. The change in the contract liability balance during the three-month period ended March 31, 2018
is the result of cash payments received and billing in advance of satisfying performance obligations, less $0.15 million of revenue
recognized during the period that was included in the contract liability balance at the date of adoption.

12

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

Contract costs

Costs to fulfill a turnkey contract primarily
relate to the materials cost and direct labor and are recognized proportionately as the performance obligation is satisfied. The
Company will defer cost to fulfill a contract when materials have shipped (and control over the materials has transferred to the
customer), but an insignificant amount of rooms have been installed. The Company will recognize any deferred costs in proportion
to revenues recognized from the related turnkey contract. The Company does not expect deferred contract costs to be long-lived
since a typical turnkey project takes sixty days to complete. Deferred contract costs are generally presented as other current
assets in the condensed consolidated balance sheets.

The Company incurs incremental costs to
obtain a contract in the form of sales commissions. These costs, whether related to performance obligations that extend beyond
twelve months or not, are immaterial and will continue to be recognized in the period incurred within selling, general and administrative
expenses.

The tables below present the impacts of
our adoption of the new revenue standard on our income statement and balance sheet.

For the Three Months Ended

March 31, 2018

As Reported

Balance Without Adoption of

ASC 606

Effect of

Change Higher/(Lower)

Income Statement:

Sales

$

1,605,196

$

1,708,196

$

(103,000

)

Cost of Goods Sold

1,054,234

1,088,734

(34,500

)

Net loss

$

1,184,166

$

1,115,666

$

68,500

March 31, 2018

As Reported

Balance Without Adoption of

ASC 606

Effect of

Change Higher/(Lower)

Balance Sheet:

Assets

Contract Assets

$

644,479

–

$

644,479

Accounts Receivable, net

–

65,400

(65,400

)

Inventories

843,488

1,046,335

(202,847

)

Liabilities

Contract Liabilities

1,670,616

–

1,670,616

Customer Deposits

–

199,483

(199,483

)

Deferred Revenue - Current

–

357,975

(357,975

)

Deferred Revenue – Long Term

–

238,426

(238,426

)

Equity

Accumulated Deficit

–

498,500

$

(498,500

)

13

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

The table below presents the cumulative
effect of the changes made to our consolidated balance sheet as of January 1, 2018 after the adoption of ASU 2014-09.

December 31, 2017

Transition Adjustments

January 1,

2018

Balance Sheet:

Assets

Contract Assets

–

110,000

$

110,000

Inventories

777,202

239,000

1,016,202

Liabilities

Contract Liabilities

–

779,000

779,000

Equity

Accumulated Deficit

$

(119,724,656

)

(430,000

)

$

(120,154,656

)

Remaining performance obligations

As of March 31, 2018, the aggregate amount
of the transaction price allocated to remaining performance obligations was approximately $1.0 million. Except for support services,
the Company expects to recognize 100% of the remaining performance obligations over the next six months.

NOTE D– ACCOUNTS RECEIVABLE

Components of accounts receivable as of March 31, 2018 and December
31, 2017 are as follows:

March 31, 2018

December 31, 2017

Accounts receivable

$

1,294,017

$

1,632,459

Allowance for doubtful accounts

(9,742

)

(22,173

)

Accounts receivable, net

$

1,284,275

$

1,610,286

NOTE E – ACCRUED LIABILITIES AND EXPENSES

Accrued liabilities and expenses at March 31, 2018 and December
31, 2017 are as follows:

March 31, 2018

December 31, 2017

Accrued liabilities and expenses

$

186,965

$

294,709

Accrued payroll and payroll taxes

314,830

230,931

Accrued sales taxes, penalties, and interest

44,149

83,282

Product warranties

55,316

59,892

Total accrued liabilities and expenses

$

601,260

$

668,814

NOTE F – DEBT

Revolving Credit Facility

The Heritage Bank Loan Agreement contains
representations and warranties, covenants, and other provisions customary to transactions of this nature. As of March 31, 2018,
the Company was in compliance with all financial covenants. The outstanding principal balance of the Credit Facility bears interest
at the Prime Rate plus 3.00%, which was 7.75% at March 31, 2018 and 7.50% at December 31, 2017. The outstanding balance on the
Credit Facility was $622,852 and $682,211 at March 31, 2018 and December 31, 2017, respectively. The remaining available borrowing
capacity was approximately $429,000 and $202,000 at March 31, 2018 and December 31, 2017, respectively.

On March 31, 2018, an amendment to the
revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the
terms of the amendment was that if the Company fails to comply with required EBITDA covenants as of any particular quarterly measurement
date, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted cash maintained
at Heritage Bank is in excess of $5,000,000.

14

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

NOTE G – PREFERRED STOCK

Preferred stock carries certain preference
rights as detailed in the Company’s Amended Articles of Incorporation related to both the payment of dividends and as to
payments upon liquidation in preference to any other class or series of capital stock of the Company. As of March 31, 2018, the
liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of $419,393,
which includes cumulative accrued unpaid dividends of $159,393, and second, Series A with a preference value of $1,544,394, which
includes cumulative accrued unpaid dividends of $619,394. As of December 31, 2017, the liquidation preference of the preferred
stock is based on the following order: first, Series B with a preference value of $414,258, which includes cumulative accrued unpaid
dividends of $154,258, and second, Series A with a preference value of $1,526,141, which includes cumulative accrued unpaid dividends
of $601,141.

NOTE H – CAPITAL STOCK

The Company has authorized 190,000,000
shares of common stock with a par value of $.001 per share. As of March 31, 2018 and December 31, 2017 the Company had 133,989,919
and 133,695,111 common shares issued and outstanding.

NOTE I – STOCK OPTIONS
AND WARRANTS

Employee Stock Options

The Company maintains an equity incentive
plan, (the “Plan”). The Plan was established in 2010 as an incentive plan for officers, employees, non-employee directors,
prospective employees and other key persons. It is anticipated that providing such persons with a direct stake in the Company’s
welfare will assure a better alignment of their interests with those of the Company and its stockholders.

The following table summarizes the changes
in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company
under the Plan as of March 31, 2018.

There were zero and 3,000,000 options granted,
1,069,075 and zero options cancelled or expired and zero options exercised during the three months ended March 31, 2018 and 2017,
respectively. Total stock-based compensation expense in connection with options granted to employees recognized in the condensed
consolidated statements of operations for the three months ended March 31, 2018 and 2017 was $1,531 and $314,686, respectively.

Warrants

The following table summarizes the changes
in warrants outstanding and the related prices for the shares of the Company’s common stock issued to non-employees of the
Company.

Warrants Outstanding

Warrants Exercisable

Exercise Prices

Number

Outstanding

Weighted Average

Remaining

Contractual Life

(Years)

Weighted Average

Exercise Price

Number

Exercisable

Weighted Average

Exercise Price

$

0.20

250,000

3.52

$

0.20

250,000

$

0.20

Transactions involving warrants are summarized as follows:

Number of Shares

Weighted Average Price Per Share

Outstanding at January 1, 2017

300,000

$

0.20

Issued

–

–

Exercised

–

–

Cancelled or expired

(50,000

)

0.18

Outstanding at December 31, 2017

250,000

0.20

Issued

–

–

Exercised

–

–

Cancelled or expired

–

–

Outstanding at March 31, 2018

250,000

$

0.20

There were no warrants granted, exercised,
cancelled or forfeited during the three months ended March 31, 2018 and 2017, respectively.

NOTE J – RELATED PARTY
TRANSACTIONS

During the three months ended March 31,
2018 and during the year ended December 31, 2017, the Company agreed to issue common stock in the amount of $36,000 and $144,000
to the Company’s non-employee directors as compensation for their attendance and participation in the Company’s Board
of Director and committee meetings.

Upon execution of their employment agreements
during the three months ended March 31, 2017, each Messrs. Tienor, Sobieski and Koch, was granted 1,000,000 stock options at their
fair market value and were scheduled to vest over a three year period. However, pursuant to their employment agreements, the stock
options vested immediately upon the sale of the Company’s subsidiary, EthoStream, in March 2017. Effective with the
sale of the assets of EthoStream LLC, Mr. Koch was hired by DCI. In compliance with the terms of Mr. Koch’s stock option
grant letter, Mr. Koch’s stock options were canceled during the period ended March 31, 2018.

During the three months ended March 31,
2017, Messrs. Tienor, Sobieski and Koch, earned a bonus of $29,250 contingent on the sale and sale price amount of Ethostream.

16

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

NOTE K – COMMITMENTS AND CONTINGENCIES

Office Lease Obligations

Commitments for minimum rentals under non-cancelable
leases as of March 31, 2018 are as follows:

2018 (remainder of)

$

156,383

2019

159,253

2020

164,903

2021

182,512

2022

190,141

2023 and thereafter

573,883

Total

$

1,427,075

Rental expenses charged to operations for
the three months ended March 31, 2018 and 2017 was $83,882 and $34,020, respectively.

Litigation

The Company is subject to legal proceedings
and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements may occur,
the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position,
results of operations or liquidity.

Sales Tax

The following table sets forth the change in the sales tax accrual
as of March 31, 2018 and December 31, 2017:

March 31, 2018

December 31, 2017

Balance, beginning of year

$

83,282

$

274,869

Sales tax collected

35,133

297,673

Provisions

6,734

(33,000

)

Interest and penalties

–

(5,890

)

Payments

(81,000

)

(450,370

)

Balance, end of period

$

44,149

$

83,282

NOTE L – BUSINESS CONCENTRATION

For the three months ended March 31, 2018,
one customer represented approximately 14% of total net revenues. For the three months ended March 31, 2017, one customer represented
approximately 11% of total net revenues. As of March 31, 2018, three customers accounted for approximately 38% of the Company’s
net accounts receivable. As of December 31, 2017, three customers accounted for approximately 54% of the Company’s net accounts
receivable.

Purchases from one supplier approximated
$760,000, or 82%, of purchases for the three months ended March 31, 2018 and $595,000, or 68%, of purchases for the three months
ended March 31, 2017. Total due to this supplier, net of deposits, was approximately $23,142 as of March 31, 2018, and $32,697
as of December 31, 2017.

NOTE M – DISCONTINUED OPERATIONS

During the year ended December 31, 2017,
the Company, and EthoStream, entered into an Asset Purchase Agreement (the “Purchase Agreement”) with DCI-Design Communications
LLC (“DCI”), a Delaware limited liability company, whereby DCI acquired substantially all of the assets and certain
liabilities of EthoStream for a base purchase price of $12,750,000. The Purchase Agreement provided that $900,000 of the $12,750,000
base purchase price was placed into an escrow account to support potential indemnification obligations of up to $800,000 and net
working capital adjustments of up to $100,000. On April 06, 2018, the Company received the $800,000 disbursement from the funds
held in escrow. The Company reclassified the balance from restricted cash to cash at March 31, 2018.

On March 29, 2017, pursuant to the
terms and the conditions of the Purchase Agreement, the Company closed on the sale.

17

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

MARCH 31, 2018

(UNAUDITED)

As of March 31, 2018 and December 31, 2017
there were no assets or liabilities of discontinued operations.

The following table summarizes the statements
of operations information for discontinued operations.

For the Three Months Ended

March 31,

2018

2017

Revenues, net:

Product

$

–

$

653,839

Recurring

–

925,837

Total Net Revenues

–

1,579,676

Cost of Sales:

Product

–

424,829

Recurring

–

209,179

Total Cost of Sales

–

634,008

Gross Profit

–

945,668

Operating Expenses:

Selling, general and administrative

–

262,034

Depreciation and amortization

–

60,420

Total Operating Expenses

–

322,454

Income from Discontinued Operations before Provision for Income Taxes

–

623,214

Provision for Income Taxes

–

51,412

Income from Discontinued Operations (net of tax)

$

–

$

571,802

The consolidated statements of cash flows
do not present the cash flows from discontinued operations for investing activities or financing activities because there were
no investing or financing activities associated with the discontinued operations in the periods ended March 31, 2018 and 2017.

18

Item 2. Management’s Discussion and Analysis
of Financial Condition and Results of Operations

The following discussion and analysis of
the Company’s financial condition and results of operations should be read in conjunction with the accompanying condensed
consolidated financial statements and related notes thereto for the three months ended March 31, 2018, as well as the Company’s
consolidated financial statements and related notes thereto and management’s discussion and analysis of financial condition
and results of operations in the Company’s Form 10-K for the year ended December 31, 2017, filed with the US. Securities
and Exchange Commission (the “SEC”) April 2, 2018.

Business

Telkonet, Inc. (the “Company”,
“Telkonet”), formed in 1999 and incorporated under the laws of the state of Utah, is the creator of the EcoSmart Platform
of intelligent automation solutions designed to optimize energy efficiency, comfort and analytics in support of the emerging Internet
of Things (“IoT”).

In October of 2016, the Company, under
the direction and authority of the Board of Directors, committed to a plan to offer for sale EthoStream LLC (“EthoStream”),
its wholly-owned High-Speed Internet Access (“HSIA”) subsidiary. While EthoStream is one of the largest public
HSIA providers in the world, providing services to more than 12.0 million users monthly across a network of approximately 1,800
locations, the Company will focus on its higher growth potential EcoSmart Platform line. As a result of this decision to sell EthoStream,
the operating results of EthoStream for the period ended March 31, 2017 have been reclassified as discontinued operations in the
condensed consolidated statement of operations. The sale closed on March 29, 2017.

The Company’s direct sales effort
targets the hospitality, education, commercial, utility and government/military markets. Taking advantage of legislation, including
the Energy Independence and Security Act of 2007, or EISA, the Energy Policy Act of 2005, and the American Recovery and Reinvestment
Act the Company is focusing its sales efforts in areas with available public funding and incentives, such as rebate programs offered
by utilities for efficiency upgrades. Through the Company’s proprietary platform, technology and partnerships with energy
efficiency providers, the Company’s management intends to position the Company as a leading provider of energy management
solutions.

Forward-Looking Statements

In accordance with the Private Securities
Litigation Reform Act of 1995, the Company can obtain a “safe-harbor” for forward-looking statements by identifying
those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual
results to differ materially from those in the forward-looking statements. Accordingly, the following “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” may contain certain forward-looking statements
regarding strategic growth initiatives, growth opportunities and management’s expectations regarding orders and financial
results for the remainder of 2018 and future periods. These forward-looking statements are based on current expectations and current
assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause
actual results to differ materially from any future results encompassed within the forward-looking statements. Factors
that could cause or contribute to such differences include those risks affecting the Company’s business as described in the
Company’s filings with the SEC, including the current reports on Form 8-K, which factors are incorporated herein by reference.
The Company expressly disclaims a duty to provide updates to forward-looking statements, whether as a result of new information,
future events or other occurrences.

Critical Accounting Policies and
Estimates and New Accounting Pronouncements

Please refer to the Company’s form
10K filed April 2, 2018 for critical accounting policies and estimates. For information regarding recent accounting pronouncements
and their effect on the Company, see “New Accounting Pronouncements” in Note B of the Notes to Unaudited Condensed
Consolidated Financial Statements contained herein.

Product revenue principally arises from
the sale and installation of the EcoSmart energy management platform. The EcoSmart Suite of products consists of thermostats, sensors,
controllers, wireless networking products switches, outlets and a control platform.

For the three months ended March 31, 2018,
product revenue decreased by 17% or $0.30 million when compared to the prior year period. The hospitality market comprised $1.20
million of product sales for the three months ended March 31, 2018, a $0.13 million decrease from the prior year period. The education
market sales for the three months ended March 31, 2018 decreased $0.09 million from the prior year period to $0.29 million, and
the Multiple Dwelling Unit (“MDU”) market decreased $0.07 million from $0.09 million at March 31, 2017 to $0.02 million
for the current period. The Company’s commitment to access distribution channels through resellers and value added distribution
partners continued to grow. Product revenue derived from channel partners increased by $0.2 million for the three months ended
March 31, 2018 compared to the prior year period.

Recurring Revenue

Recurring revenue is attributed to our
call center support services. The Company recognizes revenue ratably over the service month for monthly support revenues and defers
revenue for annual support services over the term of the service period. Recurring revenue consists of Telkonet’s EcoCare
service and support program.

For the three months ended March 31, 2018,
recurring revenue decreased by nominal amount or 1% when compared to the prior year period. Non renewals outpaced new sales.

Cost of Sales

Three Months Ended

March 31, 2018

March 31, 2017

Variance

Product

$

994,237

66%

$

1,008,045

56%

$

(13,808

)

-1%

Recurring

59,997

59%

30,018

29%

29,979

100%

Total

$

1,054,234

66%

$

1,038,063

54%

$

16,171

2%

Costs of Product Sales

Costs of product revenue include equipment
and installation labor related to EcoSmart technology. For the three months ended March 31, 2018, product costs decreased
by 1% compared to the prior year. Cost of materials decreased by 16% or $0.08 million compared to the prior year period, the result
of a decrease in sales. The Company’s use of outside contractors for installations decreased resulting in a $0.13 million
decrease in contractor services costs. The decrease in sales resulted in a $0.05 million decrease in salary, wages and travel expense.
These decreases were offset by a $0.24 million increase in inventory write offs.

Costs of Recurring Revenue

Recurring costs are comprised of labor
and telecommunication services for our customer service department. For the three months ended March 31, 2018, recurring costs
increased by 100% compared to the prior year period. This $0.03 million variance was due to an increase in salary, benefits and
temporary staffing.

Gross Profit

Three Months Ended

March 31, 2018

March 31, 2017

Variance

Product

$

509,421

34%

$

802,340

44%

$

(292,919

)

-37%

Recurring

41,541

41%

72,824

71%

(31,283

)

-43%

Total

$

550,962

34%

$

875,164

46%

$

(324,202

)

-37%

Gross Profit on Product Revenue

Gross profit for the three months ended
March 31, 2018 decreased by 37% when compared to the prior year period. The actual gross profit percentage decreased from 46% for
the three months ended March 31, 2017 to 34% for the three months ended March 31, 2018. Contributing to the decrease in margin
was a $0.24 million inventory valuation adjustment as well as increased customer discounts on product sales. The inventory valuation
adjustments were due to standard cost adjustments, the write down of obsolete inventory and a reclassification of parts that should
have been expensed.

20

Gross Profit on Recurring Revenue

The gross profit associated with recurring
revenue decreased by 43% for the three months ended March 31, 2018 when compared to the prior year period. The decrease was
directly related to the cost of goods sold salary and wage increases.

Operating Expenses

Three Months Ended March 31,

2018

2017

Variance

Total

$

1,732,598

$

2,158,058

$

(425,460

)

-20%

During the three months ended March 31,
2018, operating expenses decreased by 20% when compared to the prior year period as outlined below.

Research and Development

Three Months Ended March 31,

2018

2017

Variance

Total

$

438,780

$

378,456

$

60,324

16%

Research and development costs are related
to both present and future products and are expensed in the period incurred. Current research and development costs are associated
with product development and integration. During the three months ended March 31, 2018, research and development costs increased
16% when compared to the prior year period. The variance is due to an approximate $0.07 million increase in expenditures for consulting
offset by a $0.01 million decrease in certification expense.

Selling, General and Administrative Expenses

Three Months Ended March 31,

2018

2017

Variance

Total

$

1,276,903

$

1,769,693

$

(492,790

)

-28%

During the three months ended March 31,
2018, selling, general and administrative expenses decreased over the prior year period by 28%. For the three month comparison,
the majority of the variance is attributed to bonus and stock options granted to certain executives for $0.4 million. Salaries
and benefits decreased by $0.14 million as personal transitioned with the sale of EthoStream, LLC. The Company’s marketing
expense decreased by $0.04 million, a consulting firm was not retained and commission expense decreased. Bad debt also decreased
by $0.02 million. These costs were offset by an increase in rent of $0.05 million, the Company now leases a warehouse for inventory
storage and a $0.04 million increase in tradeshow expense.

Income from Discontinued Operations, Net of Tax

Three Months Ended March 31,

2018

2017

Variance

Total

$

–

$

571,802

$

(571,802

)

-100%

Income from discontinued operations decreased
$0.06 million for the three months ended March 31, 2018 over the prior year. For the three months ended March 31, 2018 there was
no activity from discontinued operations.

21

EBITDA from Continuing Operations

Management believes that certain non-GAAP
financial measures may be useful to investors in certain instances to provide additional meaningful comparisons between current
results and results in prior operating periods. Adjusted earnings before interest, taxes, depreciation and amortization (“Adjusted
EBITDA”) is a metric used by management and frequently used by the financial community. Adjusted EBITDA provides insight
into an organization’s operating trends and facilitates comparisons between peer companies, since interest, taxes, depreciation
and amortization can differ greatly between organizations as a result of differing capital structures and tax strategies. Adjusted
EBITDA is one of the measures used for determining our debt covenant compliance. Adjusted EBITDA excludes certain items that are
unusual in nature or not comparable from period to period. While management believes that non-GAAP measurements are useful supplemental
information, such adjusted results are not intended to replace our GAAP financial results. Adjusted EBITDA is not, and should not
be considered, an alternative to net income (loss), income (loss) from operations, or any other measure for determining operating
performance of liquidity, as determined under accounting principles generally accepted in the United States (GAAP). In assessing
the overall health of its business for the three months ended March 31, 2018 and 2017, the Company excluded items in the following
general category described below:

·

Stock-based compensation: The Company believes that because of the variety of equity awards used by companies, varying methodologies for determining stock-based compensation and the assumptions and estimates involved in those determinations, the exclusion of non-cash stock-based compensation enhances the ability of management and investors to understand the impact of non-cash stock-based compensation on our operating results. Further, the Company believes that excluding stock-based compensation expense allows for a more transparent comparison of its financial results to the previous period.

·

Bonus paid to executives upon sale of discontinued operations: The Company does not consider the bonuses of $87,750 associated with the sale of EthoStream to be indicative of current or future operating performance. Therefore, the Company does not consider the inclusion of these costs helpful in assessing its current financial performance compared to the previous year.

RECONCILIATION OF NET LOSS FROM

CONTINUING OPERATIONS TO ADJUSTED EBITDA

FOR THE THREE MONTHS ENDED MARCH 31,

2018

2017

Net loss from continuing operations

$

(1,184,166

)

$

(1,294,238

)

Interest (income) expense, net

2,530

10,353

Provision for income taxes

–

991

Depreciation and amortization

16,915

9,909

EBITDA – continuing operations

(1,164,721

)

(1,272,985

)

Adjustments:

Stock-based compensation

1,531

314,686

Bonus paid to executives upon sale of discontinued operations

–

87,750

Adjusted EBITDA – continuing operations

$

(1,163,190

)

$

(870,549

)

Liquidity and Capital Resources

The Company has financed its operations
since inception primarily through private and public offerings of the Company’s equity securities, the issuance of various
debt instruments and asset based lending, and the sale of assets.

Working Capital

Working capital (current assets in excess
of current liabilities) from continuing operations decreased by $1,590,306 during the three months ended March 31, 2018 from working
capital of $9,480,565 at December 31, 2017 to a working capital of $7,890,259 at March 31, 2018.

Revolving Credit Facility

The Heritage Bank Loan Agreement contains
representations and warranties, covenants, and other provisions customary to transactions of this nature. As of March 31, 2018,
the Company was in compliance with all financial covenants. The outstanding principal balance of the Credit Facility bears interest
at the Prime Rate plus 3.00%, which was 7.75% at March 31, 2018 and 7.50% at December 31, 2017. The outstanding balance on the
Credit Facility was $622,852 and $682,211 at March 31, 2018 and December 31, 2017, respectively. The remaining available borrowing
capacity was approximately $429,000 and $202,000 at March 31, 2018 and December 31, 2017, respectively.

On March 31, 2018, an amendment to the
revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the
terms of the amendment was that if the Company fails to comply with required EBITDA covenants as of any particular quarterly measurement
date, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted cash maintained
at Heritage Bank is in excess of $5,000,000.

22

Cash Flow Analysis

Cash used in continuing operations was
$991,884 and $1,073,493 during the three months ended March 31, 2018 and 2017, respectively. As of March 31, 2018, our primary
capital needs included costs incurred to increase energy management sales, inventory procurement and managing current liabilities.
The working capital changes during the three months ended March 31, 2018 were primarily related to an approximate $329,000 decrease
in accounts receivable, a $416,000 decrease in inventory, a $283,000 decrease in accounts payable, a $295,000 increase in customer
asset, a $124,000 decrease in customer deposits and a $273,000 decrease in deferred revenue that were both reclassified to contract
liabilities which increased $653,000 and a $219,000 increase in prepaid expenses. The working capital changes during the three
months ended March 31, 2017 were primarily related to an approximate $324,000 increase in accounts receivable, offset by an $88,000
decrease in inventory and a $74,000 decrease in accrued liabilities and expenses and a $132,000 increase in accounts payable.
Accounts receivable fluctuates based on the negotiated billing terms with customers and collections. We purchase inventory based
on forecasts and orders, and when those forecasts and orders change, the amount of inventory may also fluctuate. Accounts payable
fluctuates with changes in inventory levels, volume of inventory purchases, and negotiated supplier and vendor terms.

Cash
used in investing activities was $7,493 during the three months ended March 31, 2018. Cash provided by investing activities was
$12,431,521 during the three months ended March 31, 2017. During the three months ended March 31, 2018, the Company purchased approximately
$7,493 of computer equipment. During the three
months ended March 31, 2017, the cash provided by investing activities reflects the proceeds less adjustments associated with the
sale of the assets and certain liabilities of the Company’s wholly-owned subsidiary, EthoStream.

Cash used in financing activities was $59,359
and $1,062,129 during the three months ended March 31, 2018 and 2017, respectively. Proceeds borrowed from the line of credit were
$220,610 and cash used for payments on the line of credit were $279,969 during the three months ended March 31, 2018. The Heritage
Bank Loan Agreement for the Company’s line of credit included the Company and EthoStream,
as co borrowers. Upon closing the EthoStream sale transaction on March 29, 2017, the entire balance outstanding on the Credit Facility,
$1,062,129 was repaid

We are working to manage our current liabilities
while we continue to make changes in operations to improve our cash flow and liquidity position.

Management expects that global economic
conditions, in particular the decreasing price of energy, along with competition will continue to present a challenging operating
environment through 2018; therefore working capital management will continue to be a high priority for 2018. The Company’s
estimated cash requirements for our operations for the next 12 months is not anticipated to differ significantly from our present
cash requirements for our operations.

Off-Balance Sheet Arrangements

The Company has no material off-balance
sheet arrangements.

Acquisition or Disposition of Property
and Equipment

The Company does not anticipate significant
purchases of property or equipment during the next twelve months. The Waukesha, Wisconsin lease may require additional furniture,
shelving, computer equipment and peripherals to be used in the Company’s day-to-day operations.

Item 4. Controls and Procedures.

As of March 31, 2018, the Company performed
an evaluation, under the supervision and with the participation of management, including the Chief Executive Officer and the Chief
Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Management has identified
control deficiencies regarding the lack of segregation of duties due to the limited size of the Company’s accounting department,
a failure to implement adequate internal control over financial reporting including in our IT general control environment, and
the need for a stronger internal control environment particularly in our financial reporting and close process. We lack sufficient
personnel resources and technical accounting and reporting expertise to appropriately address certain accounting and financial
reporting matters in accordance with generally accepted accounting principles. We did not have an adequate process or appropriate
controls in place to support the accurate reporting of our financial results and disclosures on our Form 10-Q. Management of the
Company believes that these material weaknesses are due to the small size of the Company’s accounting staff. The small size
of the Company’s accounting staff may prevent adequate controls in the future, such as segregation of duties, due to the
cost/benefit of such remediation. The Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls
and procedures were ineffective as of the end of the period covered by this report.

We are reviewing actions to remediate the
identified material weaknesses. As we continue to evaluate and work to improve our internal controls over financial reporting,
our senior management may determine to take additional measures to address deficiencies or modify the remediation efforts. Until
the remediation efforts that our senior management identifies as necessary, are completed, tested and determined effective, the
material weaknesses described above will continue to exist.

In light of these material weaknesses,
we performed additional analyses and procedures in order to conclude that our condensed consolidated financial statements as of
March 31, 2018 and 2017 included in this Form 10-Q were fairly stated in accordance with GAAP. Accordingly, management believes
that despite our material weaknesses, our condensed consolidated financial statements for the three months ended March 31, 2018
and 2017 are fairly stated, in all material respects, in accordance with GAAP.

23

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

The Company is subject to legal proceedings
and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements
may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial
position, results of operations or liquidity.

Item 1A. Risk Factors.

There have been no material changes to
risk factors previously disclosed in our annual report on Form 10-K for the year ended December 31, 2017 in response to Item 1A
of Form 10-K.